Commentary: Stocks have below-average long-term potential

In fact, if you’re searching for factors that historically have had the best track record of forecasting the market’s future multi-year return, you’ll soon discover that the political affiliation of who’s in the White House is essentially worthless.

That’s just another way of saying that, when engaging in financial planning for the next decade or so, there are far more important factors on which you should be focusing than who wins the election.

Those at least are the conclusions I drew after reading a fascinating article just published by Cliff Asness, managing and founding principal at AQR Capital Management.

To be sure, the article — entitled “An Old Friend: The Stock Market’s Shiller P/E” — does not focus on politics or elections. Asness instead focuses on stocks’ current valuation relative to earnings, and finds that the market is significantly overvalued — perhaps dangerously so.

Obama, Romney deadlocked

(4:53)

Obama and Romney enter the final sprint before Election Day essentially deadlocked nationally in what looks set to be one of the closest presidential elections in U.S. history. Photo: Getty Images.

But when I added to the database on which Asness based his analysis an additional variable based on the president’s political party, I reached almost identical conclusions.

That is not surprising, considering that the years in which the market historically has been cheapest relative to earnings were fairly equally divided between Democratic and Republican presidencies — the early years of Ronald Reagan’s administration and those of Franklin Roosevelt.

And, likewise, the past years in which the market was most expensive relative to earnings were also been divided between presidencies of both parties: The latter years of Bill Clinton’s administration, as well as the early years of George Bush’s.

The valuation measure that is the centerpiece of Asness’ paper is the infamous “Shiller P/E,” named for Yale University Professor Robert Shiller. It cyclically adjusts earnings to correct for, among other things, the extreme readings that earnings register at the start and end of recessions — and is, consequently, referred to as the Cyclically-Adjusted Price/Earnings ratio, or CAPE.

Asness, like others before him, finds that the CAPE historically has had an impressive ability to forecast the stock market’s subsequent 10-year real return. (The table is based on data back to 1926.)

Decile of CAPE level at beginning of 10-year period

Bottom of CAPE range for this decile

High end of CAPE range for this decile

Average S&P 500 real return over subsequent 10 years

1 (stock market cheapest)

5.2

9.6

10.3%

2

9.6

10.8

10.4%

3

10.8

11.9

10.4%

4

11.9

13.8

9.1%

5

13.8

15.7

8.0%

6

15.7

17.3

5.6%

7

17.3

18.9

5.3%

8

18.9

21.1

3.9%

9 (where we are today)

21.1

25.1

0.9%

10 (stock market most expensive)

25.1

46.1

0.5%

As you can see, the market’s current CAPE puts it in the 9th decile, which — on the assumption that the future is like the past — translates to an expected real return over the next decade of just 0.9% annualized.

Not surprisingly, stock market bulls don’t like this conclusion, and in recent years they have lodged many objections to the CAPE.

Asness deals with a number of those objections in turn, showing that you would reach broadly similar conclusions even if you were to modify the CAPE in several of the ways often suggested. (Click here to read his article.)

The only way to wriggle out from underneath this conclusion is to focus on the traditional price-to-earnings ratio — the version that involves no cyclical adjustment. Asness reports that this traditional P/E today stands right in line with its median level since 1926 — suggesting that the market is neither overvalued nor undervalued.

But there are particularly compelling reasons to cyclically adjust P/E ratios right now.

One is the all-time high at which corporate profit margins now sit. Between 1926 and 1999, according to Boston-based money-management firm GMO, the average profit margin in the U.S. was 4.9%, less than half its current level of more than 10%.

To not cyclically adjust P/E ratios, you in effect must assume that these profit margins will indefinitely stay at or close to their current high level.

Yet that assumption is hard to justify, since historically profit margins have proven to be very cyclical. That is, every other time in U.S. history when those margins have approached current levels, they have soon come back down.

That means the path of least resistance for profit margins is to come down, even if the economy continues to gradually improve. And that in turn means we are probably deluding ourselves when we use the traditional P/E to reassure ourselves that stocks are not overvalued.

The bottom line: Regardless of who wins the presidency, the stock market has a tough decade ahead of it.

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